Optimism Part 2 – Generating Some Ideas

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

May 24th, 2018

Optimism Part 2 – Generating Some Ideas

  • We use our recent update of our long-standing Optimism analysis as an idea generator. We assume that optimists will continue to spend unwisely and that conservative companies will show better returns.
    • In an environment of very strong cash flows we believe that deal flow could increase.
    • The alternate is larger share buy-backs – such as that announced by HUN this week – one of our favorite ideas today.
  • We don’t want expensive optimists with lots of balance sheet capacity; we are much more comfortable with conservative companies with balance sheet capacity but we would rather buy them cheaply.
    • Overlaying valuation and balance sheet flexibility, we identify the companies summarized in the Venn diagrams in Exhibit 1.
  • While we are fine tuning the analysis in this report, note that we generally like conservative companies regardless of valuation and balance sheet flexibility and have the opposing view of optimists.
    • However, we need to qualify some of the conclusions in Exhibit 1, based on the work we published last week. VMI appears in the right-hand overlap but has had deteriorating optimism trends (i.e. has become much more optimistic) in recent years.
    • Note that in our recent report on WAB, which has been very middle of the pack on Optimism, a recent negative trend helps feed our concern that the company overpaid for the GE Transport business.
    • At the other end of the scale – EME has shown marked improvements in recent years and probably does not warrant the same concern as others in the overlap in diagram to the right.
  • While valuation is an important overlay in our view – a cheap company can make a bad deal and an expensive one can make a good deal. Consequently, the charts in the body of the report are worth a look.

Exhibit 1

Source: Capital IQ and SSR Analysis

Details

In the research we published last week we looked at the impacts of optimism on corporate strategy at a broad level and showed that the analysis we pioneered in 2012 is just as valid today as it was then. We subsequently took the analysis to a broad chemicals group in our monthly report earlier this week.

In this report we want to pick some stocks.

There is a price for everything – so at the right price you should buy an optimist and at the right price you should sell a conservative company. Optimists are generally most dangerous when they have plenty of free cash flow and unlevered balance sheets, and consequently an expensive optimist with M&A flexibility should be avoided.

Starting with valuation, we take our top two quintiles of optimists and plot our own discount from normal value metric against EV/EBITDA – in each case looking at how far away the company is from its own norm. There should be an overall positive bias because of the high value of the broader market, so we are looking for the outliers. Focusing on EV/EBITDA, FELE, EMR, DCI and SXT are expensive names that have a history of disappointing, but anyone on the chart is more likely to miss expectations than meet them. GE is appropriately cheap, as is UPS. We have previously and frequently written about concerns with APD.

Exhibit 2

Source: Capital IQ and SSR Analysis

We have done the same analysis at the other end of the scale looking for cheap conservative companies. We would focus on the cheap names – EMN is already on our favorites list. Note that while BLL, RS, VMI, CMI and TKR remain in this grouping, they have seen the most deterioration in behavior in recent years (see previous piece) which is likely why they are cheap – they probably represent the greatest upside potential if they can restore credibility. Other than EMN, OSK, AGCO, WOR and CR look most interesting – PPG screens well, but we have other concerns here – see recent work.

Exhibit 3

Source: Capital IQ and SSR Analysis

Second, we have looked at balance sheet flexibility for each of the four quintiles that are of interest. In Exhibit 4, we show the Optimists’ balance sheet flexibility – there is a large sub-group with plenty of room to make an overly optimistic acquisition – we are concerned about all, but APD is likely top of the list. We would be less concerned about PKG because of its extreme turnaround in optimism over the last 5 years (see prior piece) and SWK which has a very strong track record of acquisition integration and remains on our favored list.

Exhibit 4

Source: Capital IQ and SSR Analysis

At the other end of the scale we generally like the conservative group as they tend to make smart deals. EMN has been an outlier here and it is good that the balance sheet remains at least somewhat constrained – we would however be concerned about those companies that look like they are “falling off the wagon”, and CMI and VMI in particular have significant balance sheet flexibility. Both stocks are inexpensive, but this has been driven by disappointment.

Exhibit 5

Source: Capital IQ and SSR Analysis

The last time we did this work we took quite a bit of grief from holders of both FDX and Cytec – both of which had loyal followings but both screened as stand-out optimists.

  • FDX has outperformed the optimist group and the market, but has remained an optimist for the most part. The result is a company that does not have a multiple that adequately reflects its performance. In other words, the company has done well, but could have done better in our view
  • Cytec was acquired by Solvay in 2015. Cytec was another outperformer, but an optimist because it continually guided to very high numbers that it missed – growth was still great, but the multiple suffered as a result of the continual negative revisions – creating the opportunity for Solvay. Cytec shareholders did well because of the acquisition, but Solvay got a good deal because of the optimism and depressed multiple relative to growth.

©2018, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results. Sources: Capital IQ, Bloomberg, Government Publications.

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